MEDMAD Outlook: Profits Flatlining Amid Changes

Conning and Company’s work provides the insurance industry with some of the most valuable research and observations available. In the report below we present their outlook on Medical Malpractice for the coming years. The original report was entitled Medical Professional Liability – Looming Threats to Solid Performance 2013 from which we extract a summary and present it here for our readers’ benefit. The situation in New York is a difficult one. As publishers for years of New York Doctor Magazine we reported the affliction visited on doctors by the trial bar, by activist courts, by often absurd regulation, and by the simple requirement on their insurers for use of funds to sustain a pool and other like mechanisms that crowded the system. These need to be radically revisited in New York for our malpractice insurers to thrive. When I say insurers, I mean literally that: there are many risk retention groups and other forms of insuring that of course are not insurance companies. I am mistrustful of these kinds of entities unless they pass some kind of regulatory evaluation or muster. We offer this review with an eye to those who would help implement positive change in the Medical Malpractice marketplace. SA

1. Introduction Over the past several years, medical professional liability insurers have prospered. Underwriting profits have been at historically strong levels, with combined ratios well below 100%. Tort reforms, improvements in risk management, and successful defense of claims have brought down losses.

Although insurers are still writing profitable business, the future does not look quite so bright. Conning forecasts profits in this line to deteriorate in the next three years, due primarily to four emerging threats. One threat is the cyclical nature of the market, which alternates between rapid increases and decreases in pricing and premiums. Some of this is driven by competitive forces, and some by volatility and slow recognition of changes in losses. Another threat is the regulatory and judicial environment, most notably the evolving nature of tort reform and, more recently, the Affordable Care Act. These changes could drive up loss frequency and severity for insurers. A third threat is the movement of doctors from private practice into hospitals and other large institutions, many of which self-insure their liability exposures. Insurers that are concentrated in single states could be especially vulnerable to losing business. Finally, medical professional liability insurers face lower investment returns, bringing down profits. The first part of this study takes an indepth look at the major segments of the medical professional liability insurance market in the context of the coming changes. The major segments include specialists, multiline insurers, and risk retention groups. Each of these segments has different strategies, obtains and uses capital in different ways, and has found various responses to changes in the market. The next several chapters in the study explore the four emerging threats in detail, including the forces that drive them and their expected impact on medical professional liability insurers. How long will insurers be able to write profitable business, especially if rates continue their downward trend? How severely will changes in legislation, including the Affordable Care Act, affect loss costs; will companies need to contend with larger or more frequent judicial awards? How are insurers adapting to the increasing trend of physicians being employed by hospitals? And to what extent will companies be able to rely on investment income in the near future as a supplement to or replacement for declining underwriting performance? The final chapter explores ways in which the four emerging threats will affect these different segments. How will insurers respond if profit margins decline as Conning has forecast? If market conditions deteriorate to the point where peak losses occur, which segments will see companies withdraw from the market, and which segments will see companies sustain and perhaps ultimately raise rates and lead the industry into a hard market?

Conning has published a series of Strategic Studies focused on medical professional liability. 2. Executive Summary

The Medical Professional Liability Insurance Market In Conning’s outlook for the medical professional liability segment of the property-casualty insurance industry, we see a picture of declining profitability, which we believe will lead to returns on capital falling below the average for the overall industry by 2015. This is on the heels of remarkably profitable results over the past six years and represents a continuation of an underwriting cycle that has moved from extreme losses to extreme profitability and back again over the past three decades. The decline in profitability comes from three trends: continued decreases in premium that began in 2007, escalating losses over the past several years that may accelerate in the next several years for a variety of reasons, and continued declines in investment returns that supplement underwriting results and are particularly important in the medical professional liability line. Add to this a historical buildup in capital that has taken place over the past six years, which contributes to the decline in return on capital, which also will influence market dynamics in different ways. If we want to examine how the insurance industry will respond to these emerging challenges in the medical professional liability marketplace, we first must distinguish among at least three major groups of insurers addressing the marketplace:

• Specialists make up 70% of the traditional market, write predominantly medical professional liability, and are mutuals, stock companies, or reciprocal exchanges, writing in one or more states. About half of the specialists are single-state companies.

• Multiline companies make up 22% of the market and write medical professional liability as a line of insurance or reinsurance, along with other lines of insurance. Most of the multilines write in half the states or more.

• Risk retention groups make up 8% of the market, are formed by hospitals or physician groups under the Risk Retention Act of 1986, and report as insurance entities under that Act. Geographic concentration of RRGs is similar to specialists. Alternative risk retention, made up of captives and self-insurance, may represent as much as two-thirds of potential market exposures, according to an earlier Conning study. Data are limited for these structures and they are not considered as part of the insurance industry marketplace focus of this study.

The top ten specialists grew by about 50% between 2001 and 2006, before falling back 20% through 2012. They make up about 70% of the specialist segment. Some of this growth was through M&A. The top ten specialists represent about $5 billion in surplus, with premium-to-surplus leverage just under 0.5:1 and reserves-to-surplus about 1.4:1. Smaller specialists are even less leveraged, but make greater use of reinsurance. The top ten multiline insurers make up 87% of that segment and consist mainly of admitted companies, excess and surplus lines, and reinsurers. Growth patterns for the top ten multilines are similar to the specialists, although they represent about 20% of the premium volume as the specialists. However, the top ten multilines together represent about $85 billion in surplus. Their surplus applies to other lines of business as well. When surplus is allocated across lines of business, the multilines appear modestly more leveraged than the specialists as a group. Multilines use relatively little reinsurance. The top five RRGs showed considerable growth, but cumulatively represent premiums and surplus less than $180 million. Leverage ratios of premium-to-surplus and reserves-to-surplus are about equal to midsized specialists, though RRGs may accumulate more loss reserves as they mature.

To provide added insight, we list some of the specific characteristics of each of the top ten specialists, top ten multilines, and top five risk retention groups. Each of these segments has performed well in the past five years in terms of loss ratio and combined ratio. However, each will be challenged by changing conditions over the next three years: different market behavior in a continued softening underwriting cycle; changing regulatory and tort environments; a declining and consolidating physician and provider marketplace; and a declining investment environment. The Threat of the Market Cycle One danger that the medical professional liability insurance industry has faced throughout history is the cyclical nature of profits and losses. These cycles last for several years and consist of four different stages: peak losses, hard market, peak profits, and soft markets. A close examination of the parts of the cycle shows the effect of delayed recognition of changes in loss patterns and the competitive factors of strong profits and strong returns attracting new entrants and aggressive expansion.

Cycles can be observed in the volatility of the combined ratio, with the latest peak combined ratio (industry losses) occurring in 2001 and the latest low point (peak industry profitability) occurring in 2006. The combined ratio cycle is made up of two other separate cycles: a cycle of changes in losses (claims)—in turn made up of volatility in claim frequency and severity and also changes in reserves for still open claims—and a cycle of premiums that responds to both a changing claims environment and a changing competitive environment. Peak loss periods, like the one that the industry faced in 2001, tend to happen when rate changes lag rising loss costs. Loss reserves then need to be strengthened, thus reducing profitability even further. Surplus decreases substantially due to heavy loss activity, and some insurers pull out of the market, as The St. Paul Companies did in 2001.

The reduced capacity in 2001 brought on a hard market, with double- digit rate increases very common among policyholders. Higher premium rates, combined with a reversal of loss trends marked by lower frequency and moderate severity growth, led to improvements in cash flows and combined ratios. The hard market led to peak profitability among insurers, with very favorable underwriting results due in part to reserve releases. Industry capital increased substantially between 2005 and 2008, due to the attractiveness of this line of business and the surge in RRGs.

Heavy competition and abundant capital drove the softening of the market. Rates have been decreasing for the past several years, despite growth in incurred losses since 2010. Competition extends to the various states, with more companies competing in new markets as they seek to deploy capital and diversify exposure. Rising combined ratios and reduced cash flows in recent years are symptoms of market softening. Recent spikes in accident- year loss ratios and an uptick in incurred claim development also suggest that further loss deterioration is likely. The Threat of the Legal Environment In the wake of rapidly increasing frequency and severity of medical professional liability lawsuits, particularly since the late 1990s, medical providers and legislators have instituted reforms. Medical providers responded by changing the risk management model to focus on the patient. Patient safety officers encouraged greater transparency among health care professionals and, when errors did occur, many hospitals opted for full disclosure. Evidence has shown that such a policy was effective in reducing both frequency and severity of claims. Widespread tort reform also played a key role in reducing loss costs. Changes such as the limitation of economic damages, the use of alternative dispute resolution, and prescreening trials contributed to improvements in incurred losses. While tort reform efforts are continuing, they are coming under challenge in a number of states. At the same time, some evidence of increases in severity, and also of potential increases in frequency, is beginning to emerge.

Although claim frequency has continued its downward trend, the concern is the 1% of claims that exceed $2 million. In 2012, the 14 largest jury awards totaled more than $1 billion. These “headline” cases have the potential to open the door for future lawsuits as attorneys look for significantly large payments and medical providers look to settle rather than risk possible financial ruin from a catastrophic claim. Adding to the fear of higher jury awards is the likelihood of greater claim frequency resulting from the implementation of the Patient Protection and Affordable Care Act. Physicians and hospitals will have to adapt to the influx of new patients expected when the individual mandate takes effect in 2014. The impending increase in physician shortages may lead to longer waits for patients to book appointments, thus increasing the chances of complications.

Much of the increased patient load will be handled by physician extenders such as nurse practitioners and physician assistants. These professionals have had a growing presence in the medical field in recent years. Not only have they played a greater role in doctors’ offices and hospitals, but also they are commonly used in retail clinics, which are proliferating across the country. One concern is that the public may not be clear about the functions of physician extenders. The lack of understanding about their role could increase risk for medical professional liability insurers. Besides the individual mandate, the PPACA introduces other changes that could affect claim frequency. The implementation of electronic health records could lead to a greater incidence of adverse events, as medical staffs adjust to new systems and experience technical problems. Cost savings by accountable care organizations will make it more difficult for doctors to practice defensive medicine, thus increasing the potential for missed diagnoses. By the end of 2013, almost 25% of all physicians are expected to belong to ACOs. The implementation of a new system could result in additional lawsuits if the service provided by these organizations does not meet patients’ expectations. The Shifting Health Care Provider Base

The expenses and administrative burdens of the PPACA have accelerated another recent trend in health care: the consolidation of doctors into hospitals and other large medical facilities.

The movement of physicians from private practices into hospitals and other larger entities has accelerated in recent years due to higher expenses, growing administrative burdens, and a desire for doctors to live a more stable lifestyle. Hospitals, which have greater control over both doctors and physician extenders, have been motivating physicians to focus more of their time on high-risk cases, thus increasing the possibility of medical errors as physician extenders assume more responsibility for routine cases. The consolidation process presents growth challenges for many insurers that focus most of their business on physician coverage. Physicians who leave their private practices for hospitals usually give up their coverage and become insured by the hospitals. Most hospitals self-insure their liability exposures, thus reducing the potential for organic growth among insurers. While some companies have responded by introducing products that combine physician and hospital coverages, many insurers have found consolidation necessary to compete in this shrinking market. As Chapter 3 indicates, there has been a steady number of mergers and acquisitions among medical professional liability insurers in recent years. In the previous chapters, we discussed two forces that could threaten medical professional liability insurers: the market cycle and legal trends. The movement of physicians into hospitals exacerbates both of these threats. Heavier competition for a shrinking client base brings down rates, thus prolonging the soft market. As hospitals grow, the additional assets create greater incentives for lawyers to seek higher awards, thus increasing the potential for higher claim severity. Declining Investment Income Adds to Profit Pressures

Treasury rates have been declining over the past three decades, with the rate of decline accelerating since 2008. For insurers whose portfolios consist mainly of bonds, book yields have been falling, resulting in lower investment income. Continued decreases in investment income are expected as insurers reinvest their securities at lower rates.

The drop in investment income puts more pressure on medical professional liability insurers to write profitable business. In previous years, insurers had an easier time writing business at an operating profit, despite high combined ratios. With lower investment income relative to earned premium, insurers have a higher probability of writing business at an operating loss, as they did back in 2001.

Different groups of insurers implement various strategies for investments. Multiline insurers have higher durations and lower credit quality relative to specialists and RRGs, which is consistent with generally larger pools of assets to invest and a greater diversification of liabilities. Specialist companies have implemented more conservative investment strategies and, as a result, have had consistently lower investment yields relative to multiline companies. Investment strategies for smaller specialists have been extremely conservative, with many companies not even investing in equities. RRGs have had a slightly more aggressive investment policy, with relatively large allocations of equities in their portfolios and average credit quality that is comparable to that of larger specialists. Despite the drop in yields, it does not appear that medical professional liability insurers are making an aggressive attempt to increase investment income. While some insurers have made efforts to reduce credit quality and invest more money in equities, they continue to allocate much of their portfolio to high-quality bonds and do not often diversify into nontraditional asset classes. Because of this conservative investment strategy, insurers should not expect increasing investment income to provide much of a solution to falling profitability over the next couple of years.

However, there is a range of investment performance among even specialist companies that suggests some companies are more aggressive within categories in seeking added yield. Given the leverage of assets to premiums, a 100 bps (1 percentage point) overall increase in yield can be the equivalent of more than 6 points improvement when comparing the combined ratio to the operating ratio. With combined ratios and margins projected to fall in the current soft cycle, that level of improvement may become an important differentiator.

Considerations of asset allocation to include equities and alternative investment classes also may provide a path to improved returns at similar or slightly more aggressive risk levels. Many medical professional liability insurers are very strongly capitalized in the current environment and may be positioned to take additional risk in light of softening underwriting markets.

Two Possible Roads Ahead

Conning’s forecast is based on a range of assumptions regarding rate changes, loss trends, exposure drivers, and investment income. The outlook for medical professional liability is for rising combined ratios and operating ratios and declining premium.

The forecast is influenced by the four emerging threats previously discussed. The softening market likely will continue to bring down premiums through 2014, with just a small increase in 2015 in response to shrinking profit margins. Growing frequency and severity resulting from the ACA and larger jury awards likely will bring up losses, though continued reserve releases are expected to mitigate these losses. The movement of physicians to hospitals is projected to be offset by growth in physician extenders and retail clinics, while lower investment income is expected to drive down ROEs.

Because of these market drivers, the medical professional liability insurance industry as a whole will not be expected to make an underwriting profit in 2015. Multiline insurers may pull back some capital because ROEs for other major commercial lines are expected to be higher. However, most companies will still be expected to make a profit due to investment gains; no significant market movement is expected. Nevertheless, a number of factors could bring down profitability further than expected. Rates could decrease even further, the trend of physicians moving to hospitals could continue at its current pace, large jury awards could continue their growth, claim frequency could rise more than expected, and medical inflation could outpace expectations. The convergence of these forces could drive up loss ratios rapidly. Upon seeing this sudden change in trends, insurers may be less willing to release reserves, thus compounding growth in incurred losses. In this scenario, insurers would be writing business at both an underwriting and an operating loss. The above scenario would have a significant impact on medical professional liability insurers. Multiline companies likely would reduce business even further, with some companies withdrawing from the market completely. Others would respond by opportunistically increasing pricing in excess-of-loss insurance and reinsurance. A number of RRGs and other captive insurers could shut down, thus reducing capital even further. Companies and providers that seek to navigate this scenario successfully would first need to have mechanisms in place to monitor trends in losses (frequency, severity, and source of losses) in a rapidly changing health care marketplace. This will be difficult in a long-tailed line undergoing inflection points and change and will require monitoring not only claims experience, but also claims notices, tort trends, geographic differences, and provider trends. As part of this, companies would need to look for ways to improve loss experience by improving their risk management services to clients, educating medical providers on patient safety, and lobbying for tort reform.

Competitive information will be important not only to monitor needed pricing responses, but also to defend against the potential for aggressive competitor moves looking for market share. Relating to this, product development skills will be important in bringing effective products to new providers and provider structures. This includes focus on the needs of existing insureds to emphasize retention.

Finally, companies will need to look closely at investment strategies in the context of operating trends. With continued declines in core investment yields and a declining underwriting margin environment, companies will need to look at opportunities to use their investment risk capacity to help support capital preservation and growth. Capital preservation will be important for positioning companies through the cycle and to take advantage of opportunities as they emerge.

This publication has been prepared for and distributed exclusively to specific clients of Conning. Further distribution, sale, or reproduction, in whole or in part, and by any means, is prohibited. Statements and information in this report were compiled from sources that we consider to be reliable or are expressions of our opinion. The report is not intended to be complete, and we do not guarantee its accuracy. It does not constitute and must not be considered investment advice.